8.1 Firms, Opportunity Costs, and Profits
Main Topics:The Firm, Profit and Cost: When CPAs and Economists Collide, Short-Run and
Long-Run Decisions
The Firm
When we talk about consumers, it’s very easy to imagine yourself in the leading role.
However, when the conversation switches to the firm, it is often much more difficult to
visualize what it is or who we are talking about. The firm can bring to mind many things
to many different people. The firm can be an independent bookstore in your town, or it
can be Barnes & Noble. It can be a street vendor selling hot dogs, or it can be Oscar Mayer.
Regardless of the size of the business, a firmis defined as: “An organization that employs
factors of production to produce a good or service that it hopes to profitably sell.”
Profit and Cost: When CPAs and Economists Collide
Before we launch into a technical discussion of production and costs, we need to take care
of, well, a technicality. The bottom line is that the accountant sees profit differently than
does the economist.
Example:
Upon completion of her undergraduate double major in accounting and economics,
Molly creates a firm that sells lemonade on a busy street corner in her small town.
Selling cups of lemonade at $1 each, Molly sells 1,000 cups per month. The
accountant and the economist in her agree (imagine a little devil and little angel
on each shoulder—you can decide which is the CPA) that monthly total revenues
(TR) =$1 ¥1,000 cups =$1,000.
Molly’s accounting textbooks clearly state that profit (p) is calculated by subtracting
total production costs (TC) from total revenue. She rents a table from her parents at
$75 per month; spends $300 per month on lemons, sugar, and cups; and purchases a
monthly vendor’s license at $25. These direct, purchased, out-of-pocket costs are
referred to as accounting costs, or explicit costs.
Accounting p=TR -Explicit cost =$1,000 - 75 - 300 - 25
=$600, a tidy profit!
The economist on Molly’s other shoulder disagrees. Are these the only costs of running
the lemonade stand? What about the opportunity costs of resources not accounted for
above? For example, Molly has chosen to give up a monthly salary of $1,000 at a bank.
The economist knows that this opportunity cost must be subtracted from total revenue
to better measure profit ability. These indirect, non-purchased, opportunity costs are
called economic costs, or implicit costs.
Economic p=TR -Explicit cost -Implicit costs =$1,000 - 75 - 300 - 25 - 1,000
=-$400, a painful loss!
Other implicit costs borne by many entrepreneurs include the interest given up when
savings are liquidated, or rent forgone if the individual works out of a home or garage.
Here’s one way to try to keep explicit and implicit costs straight:
- Were the dollars paid to outside resource suppliers (employees, a landlord, a wholesale
food store)? Did money actually change hands? Explicit.
- Were the resources supplied by the entrepreneur herself (salary or interest given up)?
Implicit.
The Firm, Profit, and the Costs of Production ‹ 103
KEY IDEA
